Valuation Free Cash Flows - MIT OpenCourseWare

[Pages:30]Valuation Free Cash Flows

Katharina Lewellen Finance Theory II

April 2, 2003

Valuation Tools

A key task of managers is to undertake valuation exercises in

order to allocate capital between mutually exclusive projects:

? Is project A better than doing nothing? ? Is project A better than project B? ? Is the project's version A than its modified version A'?

The process of valuation and ultimately of capital budgeting

generally involves many factors, some formal, some not (experience, hard-to-formalize information, politics, etc.).

We will focus on financial tools for valuation.

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Valuation Tools (cont.)

These tools provide managers with numerical techniques to

"keep score" and assist in the decision-making process.

They build on modern finance theory and deal with cash flows,

time, and risk.

All rely on (often highly) simplified models of the business:

? Technical limitations (less now with computers) ? Versatility ? Understandable and discussible

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How to Value a Project/Firm?

Calculate NPV

? Estimate the expected cash-flows ? Estimate the appropriate discount rate for each cash flow ? Calculate NPV

Look up the price of a comparable project Use alternative criteria (e.g., IRR, payback method)

? You need to be an educated user of these

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Comparables method

Suppose you want to value a private company going public

? EBITDA = $100 million ? For a similar public company P/E = 10 ? You value the IPO company at $1,000 million

What are the implicit assumptions?

? Suppose that P = E / (r ? g) ? Then, P/E = 1 / (r ? g) ? Thus, we assume that

? Earnings are expected to grow in perpetuity at a constant rate ? Growth rates and discount rates are the same for both firms

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Internal Rate of Return (IRR)

One-period project

? Investment = 100 at time 0 Payoff = 150 at time 1

Rate of return = 150/100 ? 1 = 50% NPV = -100 + 150/discount rate = 0 Discount rate = 150/100 = 50%

? Rate of return is the discount rate that makes NPV = 0

Multiple period projects

? IRR is the discount rate that makes NPV = 0

NPV= Io

+ C1 1+ IRR

+

C2 (1+ IRR)2

+ ... +

CT (1+ IRR)T

=0

Basic rule: Chose projects with IRR > opportunity costs of capital

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Internal Rate of Return (IRR), cont.

Suppose you choose among two mutually exclusive projects

? E.g., alternative ways to use a particular piece of land

Project 1: Project 2:

cash flows -10 +20 cash flows: -20 +35

IRR=100% IRR=75%

? Which project would you choose? (costs of capital = 10%)

? Project 2 because it has a higher NPV

Other pitfalls (BM, Chapter 5)

? E.g., multiple IRR, lending vs. borrowing.

Bottom line

? NPV is easier to use than IRR ? If used properly, IRR should give you the same answer as NPV

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1. Calculating Cash Flows

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